Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 39

Choosing an Activity-Based Costing System

Pickle Motorcycles, Inc. (PMI), manufactures three motorcycle models: a cruising bike (Route 66), a street bike (Main Street), and a starter model (Alley Cat). Because of the different materials used, production processes for each model differ significantly in terms of machine types and time requirements. Once parts are produced, however, assembly time per unit required for each type of bike is similar. For this reason, PMI allocates overhead on the basis of machine-hours. Last year, the company shipped 1,000 Route 66s, 4,000 Main Streets, and 10,000 Alley Cats and had the following revenues and expenses:

PICKLE MOTORCYCLES, INC. Income Statement
	Route 66	Main Street	Alley Cat	Total
Sales	$7,600,000	$11,200,000	$9,500,000	$28,300,000
Direct costs
Direct materials	3,000,000	4,800,000	4,000,000	11,800,000
Direct labor	288,000	480,000	1,080,000	1,848,000
Variable overhead
Machine setup				468,000
Order processing				1,152,000
Warehousing costs				1,674,000
Energy to run machines				756,000
Shipping				648,000
Contribution margin				$ 9,954,000
Fixed overhead
Plant administration				1,760,000
Other fixed overhead				2,800,000
Gross profit				$ 5,394,000

PMI's chief financial officer (CFO) hired a consultant to recommend cost allocation bases. The consultant recommended the following:

		Activity Level
Activity	Cost Driver	Route 66	Main Street	Alley Cat
Setting up machines	Number of production runs	22	34	44
Processing orders	Number of sales orders received	400	600	600
Warehousing	Number of units held in inventory	200	200	400
Using energy	Machine-hours	10,000	16,000	24,000
Shipping	Number of units shipped	1,000	4,000	10,000

The consultant found no basis for allocating the plant administration and other fixed overhead costs and recommended that these not be applied to products.

Required

a.Using machine-hours to allocate production overhead, complete the income statement for Pickle Motorcycles. (See the "using energy" activity for machine-hours.) Do not attempt to allocate plant administration or other fixed overhead.

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b.Complete the income statement using the bases recommended by the consultant.

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c.How might activity-based costing result in better decisions by Pickle Motorcycles's management?

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d.After hearing the consultant's recommendations, the CFO decides to adopt activity-based costing but expresses concern about not allocating some of the overhead to the products (plant administration and other fixed overhead). In the CFO's view, "Products have to bear a fair share of all overhead or we won't be covering all of our costs." How would you respond to this comment?

Step 1 of 4

Income statement: Income statement is also called statement of revenue and expense. Income statement is one of the three financial statements, remaining two being balance sheet and cash flow statement.

The income statement measures a company’s financial performance for one accounting cycle. In this statement, total expenses are subtracted from total revenues. The income statement shows net income or loss for a particular period.

Income Statement
	Route 66	Main Street	Alley Cat	Total
Sales revenue	$7,600,000	$11,200,000	$9,500,000	$28,300,000
Direct costs:
Direct material	3,000,000	4,800,000	4,000,000	11,800,000
Direct labor	288,000	480,000	1,080,000	1,848,000
Variable overheads	939,600	1,503,360	2,255,040	4,698,000
Contribution margin	3,372,400	4,416,640	2,164,960	9,954,000
Fixed overhead
Plant administration				1,760,000
Other				2,800,000
Gross profit				$5,394,000

Variable overheads are allocated on the basis of machine hours.

Variable overhead rate can be calculated by using variable overhead divided by total machine hours.